CMHC released its quarterly housing forecast today and has changed for the 6th time, the forecast for 2010 average resale house prices!

Source: CMHC

Here is a chart showing the forecast for 2010 average resale price… the first forecast in Jan 2009 was for resale house prices in Canada to average $288100… compare that to the most recent forecast of $338900. (note the standard deviation of the forecast is $25500!)

CMHC expects resale house prices to increase in 2011

For 2011, the forecast hasn’t changed as the market conditions demand…CMHC still expects house prices to increase 1% in 2011… notwithstanding the fact that house prices have dropped about 5% the past 2 months…

(This article is applicable to CFA Level 1 Candidates but is a good review for Level 2 candidates as well.)

A lease (e.g. lease to rent a machine to make widgets) can be reported on the financial statement as a capital lease or an operating lease depending on the accounting standards & the lease classification. The key difference between the two is that a Capital lease is recorded on the balance sheet but an Operating lease is not… hence liabilities are lower.

A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership.

FASB definition: If a lease meets one or more of the following criteria, it is classified as a capital lease; otherwise it is classified as operating lease.

The [lease] agreement specifies that ownership of the asset transfers to the lessee.

The [lease] agreement contains a bargain purchase option.

The non-cancelable lease term is equal to 75% or more of the expected economic life of the asset.

The present value of the minimum lease payments is equal to or greater than 90% of the fair value of the asset.

What is the effect of choosing one lease classification type over another?

CAPITAL LEASE

OPERATING LEASE

Which lease reflects better metrics?

EFFECTS ON FINANCIAL STATEMENTS

Assets

Higher

Lower

-

Liabilities

Higher

Lower

-

Net Income (earlier years)

Lower

Higher

Operating

Cash Flow from Operations

Higher

Lower

Capital

Cash Flow from Financing

Lower

Higher

Operating

Total Cash Flow

Same

Same

-

Tax Savings

Higher

Lower

Capital

BALANCE SHEET RATIOS

Current Ratio

Lower

Higher

Operating

Working Capital

Lower

Higher

Operating

Asset Turnover

Lower

Higher

Operating

Debt-to-Equity Ratio

Higher

Lower

Operating

PROFITABILITY RATIOS

Return on Assets (ROA)

Lower

Higher

Operating

Return on Equity (ROE)

Lower

Higher

Operating

In summary, there are very few benefits of classifying a lease as capital lease vs operating lease. Operating lease acts a means of off-balance sheet financing and perhaps as a way to hide debt.

A good financial analyst should adjust the financial statements by reclassifying operating lease as a capital lease.

The Economist comments on the proposed rule which essentially wants to bring all leases on the balance sheet and eliminate operating leases:

WHEN you lease something—a boat, a warehouse, a machine for making ball-bearings—you agree to pay for it bit by bit over time. So it is like incurring a debt, say the International Accounting Standards Board (IASB) and America’s Financial Accounting Standards Board (FASB). Therefore, it should be on your balance-sheet. This new rule, proposed on August 17th by the two regulators, has shocked companies everywhere. It is up for public comment until December, but could be enacted as soon as June next year.

A survey by PricewaterhouseCoopers, an accounting firm, found that it would add about 58% to the average company’s interest-bearing debt. Not only new leases but also existing ones would immediately be subject to the new rules. On the other hand, since rents will no longer be a running expense, operating earnings could see a bump upwards. But since the downturn, many companies are close to their maximum debt limits, and the new rules could push them over the edge. Small wonder they are howling.

The new rules’ effects will vary widely. Retailers, who often lease prime property, will take a beating. Airlines, which seldom own their jets, will suffer too. Some businesses, such as utilities, will barely notice. But others will see their apparent return on capital plunge. Many firms will see their debt-to-equity ratio rise and their ability to borrow fall.

The list of companies with Operating Leases is endless. I would imagine that most of the S&P 500 will be impacted one way or the other.

And here is Mish on whether Corporations are sittings on piles of cash?

Putting two-and-two together I cannot help but wonder if some of this recent corporate “cash raising” exercise is directly related to the proposed new accounting rules. Certainly rule #1 above applies, and for some corporations the window might close in a year.

Thus, it is highly likely some corporations are “raising cash” now, just to be safe, while they still can. That is one plausible explanation for at least a part of the massive corporate debt issuance as of late.

On the other hand, since when has there been any meaningful changes in accounting rules that were not discarded, ignored, or put on the back-burner for years or decades?

In the US, there is debate within government, media and blogosphere on the role of government in the housing market… primarily in response to the poor performance of Government Sponsored housing Entities (GSE) – Fannie & Freddie… The housing GSEs were established to promote home ownership… so to fix Fannie & Freddie, home ownership needs to be fixed.

Home ownership rate (HOR) is the proportion of households who own their home (either outright or with a mortgage).

What is the situation in Canada? Since Canada supposedly lags the US housing market by a couple years… I am going to try and analyze where Canada stands and how we got here…

The Canadian housing GSE – Canada Mortgage & Housing Corporation (CMHC) was established in 1946 to solve housing shortage after WWII. Today it plays a major role in promoting home ownership by providing mortgage loan insurance since 1954.

Source: US Census Bureau via Wikipedia, Statistics Canada

Note: Unlike the US, census in Canada is every 5 years, the next one in 2011. We can perhaps expect home ownership rates to decline if Canada indeed lags US but given the recent frenzy (see here) in housing market I somehow doubt that home ownership rates will decline… just yet. Will Canada experience a housing crash like the US? I don’t think so… see earlier posts (here & here).

So what caused home ownership rates to rise dramatically from mid 1980s to 2006 in Canada? This chart tries to answer that…

Source: Statistics Canada & Bank of Canada

As mortgage rate decreased, home ownership rate increased… BUT the role of 2-key CMHC policy changes along the way is grossly understated…

1986 - Introduction of Mortgage Backed Securities – reduced the funding cost for mortgage providers by letting non-bank financiers enter the housing market, thereby increase competition and reduce the cost of mortgage for a home buyer… I do not know where we would be if there was no MBS (I believe securitization is a great financial innovation)!

1999 - 0% Down payment & 40 year mortgage terms…lets not go there, we all know how it ended!

0% down and 40 year term mortgages are no longer “legal” and are not insured by CMHC since 2008. This policy change was introduced due to rampant speculation in the housing market and a precautionary effort by Jim Flaherty to avoid a US style housing collapse.

Note: 0% down mortgages are still available by working around government policy.

Housing inventory i.e. number of homes available for sale is increasing since the beginning of 2010. See chart below and excerpt of accompanying note from Scotia Capital Economics

…in a typical year, the non-seasonally adjusted line shows inventories peaking by the very end of the year and into the very beginning of the next year. Inventories are typically low during the summer months after the Spring market has settled down. But this time, the non-seasonally adjusted stock of outstanding listings on the open market is rising appreciably during the summer. More important is that the seasonally adjusted overhang that compensates for such distortions during the year has the overhang now pushing back up towards the range of late 2008 and early 2009. On a seasonally adjusted basis, it would take about eight months to clear out the total number of listings on the market at current selling rates assuming selling activity remains unchanged [emphasis mine]

Increasing inventory is not good… we are following the same trend from mid-2008 to Spring 2009 when inventories rose from 6 month to 10 months and prices fell about 15-20%… the economic outlook then was uncertain and it is now “unusually uncertain”…